Expansions, Indicators and Assets

This is officially the longest economic expansion on record in the US. Gross Domestic Product has now increased for 121 consecutive months, outdistancing the growth in the 1990s. The economy expanded at a 2.1% annual rate from April through June, the US Commerce Department reported this morning. It was a slower pace from Q1’s surprisingly strong 3.1%, but that was expected. The US Economy is slowing, but not as fast as the rest of the world.

This sets up the Fed’s dilemma on what to do with interest rates which they’ve already indicated are going lower. The Market is assigning 100% probability of a rate cut next week. The Stock Market remains at all-time highs and is quite expensive in most gauges. That’s usually a time for rate hikes, not cuts. These are indeed unusual times.

The yield curve has been inverted for weeks. That has generally spelled trouble. The Conference Board Leading Economic Indicator is sending another signal that a recession could be on the horizon. The LEI dropped 0.3% in June, but that was after no change in May and a 0.1% uptick in April. It is down 0.2% over the past three months. Three consecutive months of declines has historically led to recession. It hasn’t happened yet. There have been some fake outs during this historic decade plus run. The LEI has turned slightly negative before on this basis a few times during the current expansion without leading to a recession. Regardless, economic growth is slowing. It’s the weakest since February 2017. This growth rate is highly correlated with the comparable growth rate for real GDP.

2 has become a magic number. GDP continues to grow around 2%. Inflation is around 2%, and the 10-year US Treasury bond yield is also around 2%. This seems to be a solid combination for the US Stock Market. There’s no bust when there’s no boom. Even though the US Economy is not booming, asset prices are. Negative interest rates overseas make ours look less low. Stocks and Houses keep rising with low rates and substantial central bank liquidity.

The Buffett Ratio says the Stock Market is expensive. Warren Buffet’s seemingly favorite indicator calculates the market capitalization of all US equities divided by nominal GDP. In Q1, it was 1.85, only a bit below its record high at the end of the Dotcom days. Is this time different? Buffett recently said that this valuation metric doesn’t reflect that both inflation and interest rates are at record lows. So apparently he is ignoring it.

Should investors be willing to pay high prices when inflation and interest rates are low, but growth is weakening? That generally doesn’t seem like a good deal. But when you consider the struggles overseas, money is proving more comfortable in American assets. The combination of low inflation and interest rates with slow growth may result in a longer-than-usual economic expansion.

The ultimate question is, should we believe the Stock Market’s upbeat message rather than the downbeat one from the Bond Market and reems of negative macroeconomic data? The Stock Market is pricing in and looking past the last 2 quarters of very slow to flat earnings growth and in many areas negative growth and saying that this deceleration is at or near a trough and will reaccelerate later this year into ’20. Contrarily the Bond Market is saying not only is growth decelerating but the deceleration will last quite a while. One could argue there is an asset bubble in place right now if growth does not reaccelerate as many assets are valued for. It is darn expensive to live in the US, particularly New York and California.

The Bond Market is the smart money. It rarely lies and is usually right. It’s never immediate. It’s not that the Stock Market is the dumb money, but the Stock Market often lacks discipline. That’s why it’s 5+x more volatile in statistical terms than the Bond Market and susceptible to booms and busts. The Fed is moving because the Bond Market forced its hand. They clearly aren’t worried that the US Economy is overheating. Are they worried that it’s about to stall or the data they see is worse than many are letting on? Outside of Wall Street a good case could be made that a fed rate cut is not required right now. We will learn a lot next week at the July meeting.

Have a nice weekend. We’ll be back, dark and early on Monday.


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